Here's the Financial Markets Stabilization Act We Should Have Seen

This comes from a comment I left on Barry Ritholtz’s “Bailout Plan Open Thread” the other evening. The basic premise is that the “Bailout Bill” as we know it basically says we need to go out and “lift” the street out of toxic crap. Then, the world will be better.

It’s at least a bit less like the Underpants Gnomes in the sense that the toxic crap and the freezing up of the credit markets are linked… However, here’s the plan we should see if we, as taxpayers, really want our money going to help us.

1. Purchase only loans or securities that have the right to control loans directly or modify loans. The magic of the C.D.O. is that it’s backed by things that are backed by other things. So, if I buy some sub-prime–backed bonds and C.D.O.’s backed by those same bonds, I’m buying two securities being affected by the same loans. Just buy the loans. With the loans being controlled by the government, they are now free to…

2. Recast all delinquent loans to be much longer, have lower interest rates, and be much harder to abuse. Guess what interest rate you get on a forty year mortgage?  A lower one! Why? Because the duration is much higher. Why? If I make five basis points per year over the life of a forty year loan I’m making more money than if I earn five basis points over the life of a thirty year loan. Thus, the interest rate where I make the same amount of money should be lower on the forty year loan. The government doesn’t even need to smash any potential profits to make loans more affordable.

3. Offer financial institutions two options: sell the government’s bailout fund loans or securities at the price the government offers to purchase them at, or sell them at their mark and give the government equity. Why? Because if the bank isn’t willing to sell at a reasonable bid, furnished by the government, then their mark is over-inflated and they are trying to avoid an adverse hit to earnings–the government should receive more compensation for bailing out the bank. This should be applied to each position one at a time–no securities should be purchased in aggregate, that’s too easy to game. As a matter of fact, that’s how sub-prime worked to begin with: pools of loans got more and more barbelled and the bottom loans defaulted. On average they were normal, in reality they were crappy enough to break the securities. Oh, and the equity should have voting rights. Of course, there are questions to be answered.

4. Lend directly to people and small businesses. If the economic fears are all about the seizing up of the credit markets, we should be able to fix these problems by lending to those that live and die by financing. Create very strict standards for qualifying for these loans. FICO and income requirements, unlike sub-prime loans had. For businesses, underwrite loans to actual income and asset levels and only lend very conservative amounts of leverage.

5. Immediately raise capital requirements across the board. As Steve Davidoff notes (Lesson #4 when one follows that link), when you need to raise capital the most, you can’t. He concludes, as I have before, that this is a wonderful argument for raising capital requirements. Also, less levered institutions are more sound in general–there is more room for error. And, as one could guess, the competitive “flavor of the day” businesses, like C.D.O.’s and sub-prime, are much more levered because financing these products is viewed as a way to win business. This is why the institutions with cheap balance sheet are experiencing huge writedowns due to counterparty exposure with financing arrangements. Citi disclosed writedowns of  billions in warehouse lines where C.D.O. issuers were holding bonds with nearly no equity, on Citi’s balance sheet.

6. Required compensation reform. It’s well documented, conjectured, and even assumed that Wall St.’s compensation scheme is to blame for a lot of the mess we’re in. Swing for the fences and jump ship to another bank if it doesn’t work. That’s what it seems the most recent round of large bonuses for executives and traders that caused this problem were following. It’s simple, if you need money from the American people, you sign on to these reforms. Otherwise one might encounter a moral hazard due to government subsidized capital. Honestly, it shouldn’t be that hard to come up with an onerous set of restrictions and requirements for paying people exorbitant sums of money.

7. Immediate and broad consumer protections and consumer financial product reform. Rather than have banks start to do whatever they want to reduce their risk (I’ve heard reports of people with home equity lines in good standing paying their bill one day late and having the entire line canceled) require they treat their consumers fairly. Completely restrict the ability for banks to raise rates on things like credit card debt–to retroactively increase rates on existing debt is ridiculous in the first place. In an economy driven by spending and credit, for better or worse, putting consumers further at risk of defaulting on their obligations is stupid.

Eliminate binding arbitration of consumer debt–just invalidate it completely, retroactively. I would prefer this practice be eliminated altogether, but if we’re keeping to the topic at hand I’ll only put forth that proposal. Lastly, put strong disclosure requirements in place for all consumer debt products, including new loans or recast loans. Require institutions to show the annualized rate, over the life of the loan, if interest rates rise 2%, 4%, 5%, and if the forwards are realized. Require large print, plain English disclosures. Some people will say I'm trying to babysit people, but, honestly, how can one argue against requiring banks telling their customers basic information about their loans? Right, one can’t.

This is what we should have gotten to both get the economy and markets moving in the right direction and ensuring the confidence in institutions and consumers are both restored. Just my opinion..

Comments

[Amicus:]

Feedback, for your amusement:

1. Keep people in their homes - good for the economy, good for a slow home-price adjustment process. Government offers terms to the existing lenders and 50% participation in home price declines. Government offers reasonably close-to-market terms for those with ridiculous sub-prime or alt-a loans.

The worst-case scenario for the mortgage pools behind a CDO, under this plan, is that it is converted into a government-backed, yield-enhanced bond at maybe 16%-22% off of original face value (based on home price declines of 30-40% and 90-95% of LTV assumptions) and with maybe a 4% default rate (those homeowners who cannot meet even the government's reduced terms).

This is a Brady plan for sub-prime and alt-A mortgage debt, focused on those near or at default, that doesn't promise no defaults, keeps people in their homes as long and as much as possible, and shares the burden between lender and borrower, circa 50% in the "workout".

2. No "loan modification". The lender chooses to accept the governments (generous terms) or the risk of a costly, lengthy foreclosure process, as well as the associated home price risk. You can bet that, until house prices stabilize, most of them - well, their servicing agents - will go for the government terms.

4. yes and no. A limited amount of direct assistance, but it is better to get people jobs and to target stimulus to other things, than to start subsidizing lending.

5. absolutely not. For a time, the economy can run with ... less capital.

6. yes, but have no faith that "smart regulation" is ever anything that would make it to a final Congressional Bill.

7. We've done what needs to be done to supervised mortgage lending, but doubling the watch, so to speak, on all these other kinds of abuses, including a look at bankruptcy "relief", is probably a GREAT idea.

2008 Oct 14 08:17 PM